December 2018 Market Commentary

Global equity markets suffered large losses in December as investors overlooked the strongest economic and earnings growth in over 10-years and focused instead on rising uncertainty over the direction of trade and monetary policy and their implications for interest rates and global economic growth in the year ahead. After reaching record highs in September, the S&P 500 index lost 13.5% in the 4th quarter leading U.S. equity prices to their worst annual performance in a decade, down 4.4% for the year. This followed gains of over 21% for 2017. As investors exited equities for the safety of U.S. Treasuries, bond prices rallied, driving interest rates lower and leading core bond portfolio returns higher for the month. The yield on U.S. 10-year Treasury bonds fell from 3.23% in November to 2.62% at year’s end.

The following table contains a summary of December and year-to-date market performance:

Index December YTD Index December YTD
S&P 500 (Total Return) -9.03% -4.38% All Country World Index (Net) -7.04% -9.42%
MSCI EAFE (Net) -4.85% -13.79% Barclays Aggregate +1.84% +0.01%
MSCI Emerging Markets (Net) -2.66% -14.58% 60/40 Blend* -3.49% -5.64%

* 60% All Country World Index/40% Barclays Aggregate

December exhibited large swings in day-to-day performance. The S&P 500 suffered its largest monthly loss since 2009 and worst December dating back to the Great Depression in the 1930s. A Christmas Eve plunge of nearly 3% followed by a record-setting 5% spike on December 26th highlighted the month’s roller coaster price action. After being largely absent in 2017, volatility was front and center in 2018, with the S&P 500 recording 110 daily market swings of 1% or more compared to 10 for all of 2017.

At its record high in September, the S&P 500 had gained 13% for the year driven largely by positive news about U.S. economic and corporate earnings growth. However, as the fourth quarter unfolded, the market’s nearly 20% decline, which was mostly absent weak economic data, saw deteriorating investor sentiment drive the sell-off following a series of policy announcements that could lead to slower growth in 2019.

December began with markets reacting positively to an announced “ceasefire” in the U.S. – China trade dispute following President Trump and Chinese President Xi Jinping’s dinner at the G-20 summit in Argentina. But sentiment turned negative quickly as details of the truce indicated little had been agreed to, and was followed by statements from President Trump that only time will tell “whether or not a REAL deal with China is possible” and that China should remember “I am a Tariff Man” if a deal is not reached. At nearly the same time it was announced that Canada had arrested, on behalf of the U.S., the Chinese CFO of Huawei Technologies on a number of charges related to evading U.S. curbs on trade with Iran. The arrest and lack oftruce details led markets to question the likelihood that a comprehensive trade agreement would be reached by March 1. The S&P fell nearly 6% in the next week. Oil prices fell nearly 3% and European stocks fell by over 3% on the day of the arrest (their worst daily loss since Brexit) on concerns that a failure to resolve the trade dispute would lead to slower growth for Europe and across the world. The price of a barrel of Brent oil, which began December at nearly $62, fell to $50 during the month.

Stocks continued to lose value over the month as investor concerns that the trade dispute would lead to slower global growth in 2019 accelerated. China reported weaker than expected industrial output. Industrial production growth slowed to 5.4% year-over-year in November, down from 5.9%. Chinese auto production in particular fell sharply, declining 16.7% year-over-year on falling domestic and global demand. Chinese retail sales growth lost momentum, climbing 8.1% year-over-year, but down from 8.6% in October. U.S. economic data released during the month revealed continued strong but decelerating growth. The U.S. manufacturing PMI fell 1.4 points month-over-month to 53.9, an 11-month low. New order growth was its weakest in over a year, and growth in manufacturing employment was its softest since August 2017, attributed to negative effects on global exports arising from the trade war. Eurozone economic data also suggests continued but slowing growth. A key measure of European manufacturing hit a 49-month low and the ECB lowered its 2018 and 2019 GDP forecasts to 1.9% and 1.7%.

Falling sentiment has expanded beyond investors and is having some impact on consumer and small business sentiment. The percentage of Americans viewing the economy as excellent or good dropped 8% to 50%, while those believing the economy will improve dropped 5% to 31%, bringing it back down to the long-run average. The small business optimism index fell from an all-time high of 107.4 in October to 104.8. The decline was attributed to expected business conditions, expected retail sales and rising compensation costs.

While the market largely expected the Fed to raise its policy rate to 2.5% in December, investors were surprised by the FOMC’s accompanying statement regarding future policy decisions. Ahead of the Fed’s meeting, investors were forecasting one or fewer rate hikes in 2019. Investors also expected the Fed to move away from language suggesting “further gradual” increases to more “dovish” language indicating additional rate hikes would be data-dependent. Instead, the Fed’s statement indicated it believed the economy would continue to grow in 2019, allowing two or more rate hikes in 2019.

The failure of the Fed to iterate a more dovish policy that the market expected, suggestions that President Trump considered replacing Fed Chair Powell, and calls to major banks by Treasury Secretary Mnuchin that spooked investors, all contributed to the S&P 500 plunging nearly 6% between the Fed’s December 19th decision and the market’s December 24th low.

Despite strong U.S. economic growth, over 20% earnings growth and trend-like economic growth across the globe, equities lost value in 2018 driven by rising investor pessimism about the prospects for 2019. The overwhelming preponderance of the data, however, suggests the U.S. and global economies will continue to grow in 2019, albeit at a slower pace. Corporate earnings are forecast to grow at rates greater than GDP growth. While the S&P 500 has fallen from a high of 2930 to 2510 or nearly 15%, forecast earnings growth has been revised downward by less than 2%. As a result, stocks are selling for a P/E ratio of approximately 14X 2019 forecast earnings, less than the 18X multiple stocks sold for at the beginning of 2018.

Should the Trump administration reach an agreement with China that stabilizes global trade, it would likely catalyze markets to raise expectations of growth in the year ahead and drive equity prices higher, particularly throughout emerging markets, centered around Chinese equities. At the present time, Caprock believes U.S. and Chinese policy makers will produce an agreement that reduces the risk of a global slow-down; the costs of not doing so are too high. Any evidence that a growth-sustaining solution is unlikely would lead Caprock to recommend investors reduce their allocation to global equities sooner than would otherwise be the case.

Based on fundamentals, equity markets are still positioned to move higher from current levels. However, the upside opportunity relative to the downside risk is becoming increasingly less attractive and markets are becoming more volatile. Historically in this kind of environment, disciplined/regular rebalancing to target weights has proved to be a capital preserving strategy by reducing exposure in rising markets and adding to positions opportunistically as the market trades lower. As a result, Caprock continues to believe rebalancing to target allocations remains a smart discipline at this stage of the market cycle.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but Caprock makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.